If you are a potential home buyer, you have more than likely heard the terms fixed rate home mortgage and adjustable rate home mortgage. A fixed rate loan maintains the same interest rate for the entire length of the loan. With an adjustable rate mortgage (ARM), the interest rate changes to a higher or lower rate at various times until the loan has been paid off.
A Look at How an Adjustable Rate Home Mortgage Works
In most cases, an ARM’s introductory rate is lower than that of a fixed rate loan. However, the rate is attached to an index that operates separately from the lender. Many banks choose to use a government index, such as the One Year Treasury Spot Index. Your ARM is typically several points higher than the index. The difference between the two percentages is referred to as the margin. It is usually two to three points. When the index goes up or down, your ARM also goes up or down proportionally, while the margin stays constant.
How high can an ARM go?
Most adjustable rate mortgages include a cap, or a limit on how high the interest rate can be raised during the life of the loan. While lenders are not required to offer caps, most choose to do so. The average cap is five to six percent higher than the initial rate. Adjustable rate mortgages include adjustment periods, which are points in time when the interest rate can be changed. While they differ based on the lender and program, they commonly average from six months to three years. If an interest rate is scheduled to be changed, the law requires that a borrower be given advance warning.